Dell Lifts Default Risk on Next Buyout Targets: Credit Markets

By Mary Childs -
Jan 25, 2013

Derivatives traders are beginning to
speculate that the potential leveraged buyout of computer maker
Dell Inc. (DELL) marks the return of credit-busting takeovers as the
cost of financing the deals gets ever cheaper.

The cost to protect against losses on Quest Diagnostics
Inc. (DGX) bonds reached a 15-month high yesterday and Nabors
Industries Ltd. (NBR) credit-default swaps jumped to the most since
July amid speculation they may become targets for leveraged
buyouts. A benchmark gauge of U.S. corporate credit risk rose on
the speculation, according to Bank of America Merrill Lynch
credit strategists.

Record-low borrowing costs in the market for junk bonds,
where LBOs are financed, is combining with rising confidence in
the financial system to boost bets that a successful Dell deal
will be followed by others. Private-equity funds have $360
billion of committed unspent capital dedicated to buyout funds
in the global market, according to data from London-based
research firm Preqin Ltd., providing plenty of firepower for
more LBOs.

“It’s really now that, for the first time, uncertainty has
declined so much that private equity firms have the confidence
to pull off LBO deals,” Bank of America Merrill Lynch credit
strategist Hans Mikkelsen said in a telephone interview. LBO
risk is one of his “big themes” for the first half of this
year, “because there’s now a window of opportunity before
interest rates increase for these deals,” he said.

‘Coming Together’

“It’s sort of all coming together now: declining
uncertainty and banks are ready to fund, and the market is wide
open, and interest rates are extremely low,” said Mikkelsen,
who is based in New York.

Dell, the third-biggest maker of personal computers, is
edging toward an LBO with Silver Lake Management LLC, and
Microsoft Corp. (MSFT) is planning to provide part of the funding,
people with knowledge of the matter said. Chairman and Chief
Executive Officer Michael Dell, the top shareholder in the
computer company that has a market value of $22.6 billion, would
roll his stake into the buyout, a person with knowledge of the
matter said.

Markit CDX

Elsewhere in credit markets, the cost of protecting
corporate bonds from default in the U.S. fell. The Markit CDX
North American Investment Grade Index, a credit-default swaps
benchmark used to hedge against losses or to speculate on
creditworthiness, decreased 1.6 basis points to a mid-price of
84.9 basis points as of 11:30 a.m. in New York, according to
prices compiled by Bloomberg.

The measure typically falls as investor confidence improves
and rises as it deteriorates. The contracts pay the buyer face
value if a borrower fails to meet its obligations, less the
value of the defaulted debt. A basis point equals $1,000
annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of
debt-market stress, increased 1.07 basis points to 16.44 basis
points as of 11:31 a.m. in New York. The gauge widens when
investors seek the perceived safety of government securities and
narrows when they favor assets such as company debentures.

‘Tough Road’

Bonds of Charlotte, North Carolina-based Bank of America
Corp. are the most active dollar-denominated corporate
securities today, accounting for 5.7 percent of the volume of
dealer trades of $1 million or more as of 11:31 a.m. in New
York, according to Trace, the bond-price reporting system of the
Financial Industry Regulatory Authority.

Credit-default swaps on Dell were the ninth most traded
contracts among 1,000 tracked by the Depository Trust & Clearing
Corp. in the week through Jan. 18, up from 71st place the week
before. Swaps covered a daily average of $300 million of the
company’s debt, compared with an average of $100 million over
the past month, DTCC data show.

A Dell buyout doesn’t signal the return of multi-billion
dollar private equity deals, according to Blackstone Group LP (BX)
Chief Executive Officer Stephen Schwarzman. The Dell deal, which
Blackstone didn’t consider joining because the PC business “is
a tough road,” has a “pretty unique set of circumstances with
a fundamentally unleveraged company with an owner and founder
that can put up a lot of the equity to make the deal happen,”
Schwarzman said in a Bloomberg Television interview with Erik
Schatzker at the World Economic Forum in Davos, Switzerland.

Blackstone, the New York-based alternative-asset manager
that oversees $205 billion, invested about $4 billion out of its
$16 billion leveraged-buyout fund last year, he said. The
private equity business, in which funds seek to improve
performance at the companies they acquire or expand them before
selling them within five years, “has a reasonable level of
activity,” Schwarzman said. “The deals aren’t as big, but
there are plenty of interesting opportunities.”

‘Interesting Opportunities’

Loan prices have risen to 97.72 cents on the dollar, the
highest since July 2007, from 59 cents in December 2008, as
concern eases that the world’s largest economy will slide back
into recession. Leveraged loans and high-yield, high-risk bonds
are rated below Baa3 at Moody’s Investors Service and lower than
BBB- at S&P.

Issuance of collateralized loan obligations, which group
high-yield, high-risk loans and slice them into securities of
varying risk and return, peaked in 2007, pooling about $105
billion to invest in junk-grade loans, according to Wells Fargo
& Co., which estimates that as much as $80 billion could be
raised this year. That would surpass the $55 billion of new CLOs
in 2012, which topped the bank’s original forecast for just $12
billion in 2012.

Record Pace

Investors have funneled cash into junk bonds at a record
pace, pushed into higher-risk assets as the Federal Reserve
holds benchmark interest rates between zero and 0.25 percent and
buys back bonds to suppress borrowing costs.

Strong demand for debt and low borrowing costs will lure
would-be acquirers who need to put money to work, according to
Marty Fridson, the chief executive officer of FridsonVision LLC,
who began trading corporate debt in 1976.

“Once you raise a $10 billion fund, you don’t want to give
it back because you can’t find deals to do, so the tendency is
to rationalize, justify deals that are now very competitive,”
Fridson said.

‘Large Impact’

There will be about $135 billion in LBO volume this year,
compared with an average of $100 billion during the past two
years, and below the $600 billion annual peak of 2006 and 2007,
he said.

Credit-default swaps typically surge on LBO speculation
because the debt added to a company’s balance sheet to fund the
takeover erodes its credit quality and leads to ratings
downgrades.

“As the recent experience with Dell illustrates, the risk
of LBOs has a particularly large impact” on Markit’s
investment-grade benchmark, pushing it a net 2 basis points
wider, Bank of America’s Mikkelsen and Yuriy Shchuchinov wrote
in a Jan. 23 note. Their model shows 14 percent of the index’s
underlying credits are feasible LBO candidates.

Credit-default swaps on Quest Diagnostics have climbed 38.5
basis points to a mid-price of 123 basis points since Bloomberg
News first reported Dell’s buyout discussions with private-
equity firms, according to data provider CMA, which is owned by
McGraw-Hill Cos. and compiles prices quoted by dealers in the
privately negotiated market.

Buying Protection

That was “precipitated by investors’ buying protection on
names that have traditionally been considered LBO candidates,”
following the Dell news, according to at note dated Jan. 23 from
Barclays Plc analysts led by Shubhomoy Mukherjee.

Buyout firms announced a record $1.6 trillion of
acquisitions from 2005 to 2007. The end of that era was “quite
painful for many overleveraged deals and many PE firms and their
investors have continued their long wait to reach that point
where they can exit and take their gains,” CreditSights Inc.
analysts Glenn Reynolds and Ping Zhao wrote in a note.

‘Competitive Pressure’

The size of the Dell transaction means “all of a sudden
the theory that the next LBO cycle will have a more restrained
and manageable deal size with less HG bondholder damage will be
justifiably questioned,” they wrote in the Jan. 20 note titled
“LBO Risk Revisited for HG Bonds.”

“The deal raises the bar on average deal size and opens up
a world of competitive pressure for other private equity firms
and banks in a business that begs a ‘me too’ response.”

LBOs bigger than $20 billion are difficult to make
profitably and the track record of such deals hasn’t been good,
according to David Rubenstein, co-chief executive officer of
Carlyle Group LP. (CG)

“Large buyouts might work, but this history of buyouts
with $20 billion or more price tags has not been filled with a
lot of success,” he said yesterday in an interview with
Schatzker. “You’ve got to work very hard to make those deals
work, and good luck to them if they pull it off.”

While Barclays strategists including Ryan Preclaw don’t
expect an LBO boom, “credit markets can certainly bear a deal
in the $20 billion range of a Dell LBO, but practical
constraints on private equity firms are likely to put the upper
limit on the total number” of deals bigger than $10 billion,
they wrote in a Jan. 18 note.

‘LBO Conversation’

Total LBO enterprise value will reach at most $75 billion
this year, with more deals in the $1 billion to $2 billion
range, including smaller units spun out rather than full-scale
company purchases, Preclaw said in a telephone interview.

Preclaw expects LBO volume to run at a “normal rate,”
rebounding from 2008 and 2009, he said. “There will be deals,
but you shouldn’t expect them to be so many that they really
start to overload the market.”

Any company with cash on its balance sheet, little debt,
real estate, a known brand, and a sagging stock, will “be in
the LBO conversation,” according to Robert Smalley, a credit
strategist at UBS Securities LLC in New York.

Investors are “yield-starved, and banks are willing to
lend, so that spells more higher-yielding transactions,” he
said in a telephone interview. “The volume’s definitely been
turned up.”